Macro-Prudential Policy in a Fisherian Model of Financial Innovation

55 Pages Posted: 1 Nov 2012

See all articles by Javier Bianchi

Javier Bianchi

Federal Reserve Banks - Federal Reserve Bank of Minneapolis

Emine Boz

International Monetary Fund (IMF)

Enrique G. Mendoza

University of Pennsylvania; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: July 2012

Abstract

The interaction between credit frictions, financial innovation, and a switch from optimistic to pessimistic beliefs played a central role in the 2008 financial crisis. This paper develops a quantitative general equilibrium framework in which this interaction drives the financial amplification mechanism to study the effects of macro-prudential policy. Financial innovation enhances the ability of agents to collateralize assets into debt, but the riskiness of this new regime can only be learned over time. Beliefs about transition probabilities across states with high and low ability to borrow change as agents learn from observed realizations of financial conditions. At the same time, the collateral constraint introduces a pecuniary externality, because agents fail to internalize the effect of their borrowing decisions on asset prices. Quantitative analysis shows that the effectiveness of macro-prudential policy in this environment depends on the government's information set, the tightness of credit constraints and the pace at which optimism surges in the early stages of financial innovation. The policy is least effective when the government is as uninformed as private agents, credit constraints are tight, and optimism builds quickly.

Keywords: Financial Crises, Financial Innovation, Macro-prudential Regulation, Bayesian Learning, Economic Models, Macroprudential Policy

JEL Classification: D62, D82, E32, E44, F32, F41

Suggested Citation

Bianchi, Javier and Boz, Emine and Mendoza, Enrique G., Macro-Prudential Policy in a Fisherian Model of Financial Innovation (July 2012). IMF Working Paper No. 12/181. Available at SSRN: https://ssrn.com/abstract=2169726

Javier Bianchi

Federal Reserve Banks - Federal Reserve Bank of Minneapolis ( email )

90 Hennepin Avenue
Minneapolis, MN 55480
United States

Emine Boz

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Enrique G. Mendoza

University of Pennsylvania ( email )

Philadelphia, PA 19104
United States

HOME PAGE: http://www.sas.upenn.edu/~egme/index.html

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Register to save articles to
your library

Register

Paper statistics

Downloads
29
Abstract Views
452
PlumX Metrics